Average Office Employment Growing at Rate of a Little Over 2%, Demand for Space Growing at Just Half That Rate During First Quarter
The slow but steady progress in the recovery of the U.S. economy continued to present somewhat of a conundrum for the U.S. office market in the first quarter. On the one hand, despite moving in fits and starts, the recovery has helped stablize the office market and support relatively high property valuations. On the other, the modest job growth seen to date has yet to translate into meaningful demand for office space
, so office rents have remained at 'discount' levels.
While average office employment is growing at a rate of a little over 2%, demand for space is growing at just half that rate. That apparent disparity between office job growth and actual demand for office space was perhaps the most telling indicator of the office market's performance in the first quarter of this year, according to CoStar Group's First-Quarter 2013 Office Review and Outlook.
In a striking example, Dallas/Fort Worth, a major office market is increasing jobs at a rate of almost 4%, while use of space is growing by only 1.4%, noted Managing Director Hans Nordby, who presented CoStar's first-quarter analysis, along with Director of Office Research Walter Page and Manager of U.S. Market Research Aaron Jodka.
For the next five years, CoStar's PPR division forecasts a 30% discount across the country between office-using job growth and demand for space.
"We need to eat up a lot of excess space from the last cycle," Nordby said.
At the same time Nordby noted, "We think the office vacancy recovery is less than halfway done. We have more upside in occupancy in the office sector than any other property type that we track."
The uneven pace of recovery was reflected in the comments of webinar attendees surveyed by CoStar following the office market presentation:
"What we are seeing is that even once office employment numbers heal, they will do so at a pace unequal to absorption," said Ben Keddie, vice president of Coldwell Banker Commercial Elite in Fredericksburg, VA. "What the Great Recession has taught most companies is that in order to be profitable, efficiency and a nimble ability to adjust to changing market conditions is key. We are seeing and continuing to expect the amount of square feet per employee to decrease."
"The Bay Area marketplace is enjoying an astounding recovery," said Alan Schultz, senior managing consultant/principal with Paradigm Tax Group, which provides management of property tax assessments and valuation services and has visibility into the concerns of REITs, corporations and other investors as well as tenants. "However, that recovery has been dispersed, with significant differences between submarkets."
"In Chicago, rental growth appears to be pretty stagnant outside of the A properties," said David Martin, an office and industrial specialist associate with Marcus & Millichap focusing on the northwest suburban Chicago market. "We have not seen the tickle down or overflow effect into the B properties that we expected. Landlords are still offering heavy concessions in the suburban markets and are fighting for tenants. Any new office construction in the suburban markets will further dilute the available office space."
Despite the spotty, bifurcated recovery, the general trend of the U.S. office market is good as vacancy rates fall steadily from a post-recession high of 13.5%, edging down another 10 basis points in the first quarter to 12.2%.
Leasing activity was down slightly year over year and average rents increased 1.3%, with the best quality buildings increasing about 2%.
First-quarter 2013 office absorption was mixed - stronger than a quarter ago but weaker than a year ago, with demand tempered at the start of the year by worries about sequestration, among other concerns.
Office landlords are feeling better, but not great, as evidenced by the 4 percentage point spread between the U.S. availability and vacancy rates -- as wide as it’s been to date during the downturn and the recovery, Jodka said.
By comparison, in 2006-07, the gap was closer to a 2 percentage points. In general, though, more markets are starting to reach a vacancy level that supports rent growth.
A year or two ago, the only markets gaining occupancy were tech and energy market. Now, in addition to San Jose and Houston, they include Phoenix (2.2% gain in occupancy), where back office and homebuilding are back; and Las Vegas (1.6%), where housing and jobs are starting to recover.
The gradual expansion of occupancy gains across more markets is a major reason for the higher expecations in the office sector.
Another big reason is that the continued dearth of new construction. Only 875,000 square feet in net completions of new office buildings were logged in the quarter. The supply and demand balance reflected the fact that 3.8 million square feet of office space was removed from the market via repositioning or demolition, Page said. Many older, outdated office buildings are being converted into rental apartments.
"We’ve been seeing this type of removal activity across the markets, so we’ve actually delivered a lot more than 875,000 square feet. A lot of that space has been removed to make way for apartments," Page said.
One telling example is the Sony Building in New York. Sony Corp. of America sold its headquarters at 550 Madison Ave. for $1.1 billion, a whopping $1,290 per square foot. The Chetrit Group, LLC, headed by investor Joe Chetrit, acquired the 53-story Madison Avenue office icon in an auction that reportedly included 20 bidders.
However, arguably one of the best office buildings in the world and the largest office investment transaction of the first quarter won't even remain an office building
. Under Chetrit's plans, it will go residential via a mix of tony condominiums, a hotel and luxury retail, perhaps fetching more than double the price per square foot as residential.
"This is another thing that is really outside the box with regard to how markets behave," said Nordby. "If we continue to see some of the best assets in CBDs taken out for residential, that will portend well for the office buildings that are left, and it can create some really crazy pricing solutions. Based on what residential sells for in New York, the Chetrit Group thought it made sense."
Despite the removals and demolitions, about 70 million square feet of office construction is under way across the country, Jodka said.
"Supply is going to start hitting and that will start to change the story," he said. However, because there’s so little supply, demand will directly compress vacancy rates, fuelling stronger rent growth, Jodka said.